by Hal Eddins, Managing Director, Capital Investment Council
Last December, we were asked by the Raleigh News and Observer for our 2006 market predictions. We based our answer on valuation and past historical models, and came up with 14%. As of the Monday before Thanksgiving, the S&P 500 was up 13%. That’s close enough for government work, but what we really want to know is the health of the market at these levels. Just as we’d hoped, the mid term elections produced a banner period for stocks. It’s hard to believe that in late July, the markets were flat on the year. In the wake of the market’s strong run, we came across an interesting strategy in the Financial Times. Aronson, Johnson, and Ortiz, an asset manager from Pennsylvania, follow the basic strategy of buying the cheapest 10% of all stocks based on earnings and shorting the most expensive 10%. Simple in its approach, this method has yielded returns of 8.4% over the last 44 years. However, in times of extreme valuation shifts, the strategy “stops working” as common sense goes out the window and investors buy what’s already high and sell what’s already cheap. March of 2000 was a time in which the AJO strategy failed to work. The AJO strategy tends to be a contrary indicator, and you won’t be surprised to learn that the AJO strategy has begun to falter in the last six weeks. The S&P 500 has marched from 1231 on July 18 to a recent 1406. That’s a 14% run in 4 months. It just might be time for a rest. We believe that the markets are set for a pause that refreshes. In fact, we would welcome a pause as it would permit us to buy many of the companies we are eagerly eyeing.
If you have teenagers, you’ve probably heard all about Sony’s new PlayStation 3. The PS3 was released last week at a list price of $600. I thought the $400 I forked out for the XBOX 360 last year was expensive, but Sony is taking prices to another level. Just how crazy is the PS3 mania? I heard a story of a bond trader who bought one on EBAY last week for $1000 after being unable to buy one at the stores. He soon saw that he could flip his PS3 for a $2000 gain, so he promptly did. He became so enthralled with the process that he bought and sold another 2 units. This brought his weekly profit in trading PS3’s to $6000!!! Not bad for a side job.
Just how talented are CEO’s? The pay packages that today’s captains of industry command are much higher than 25 years ago. However, the talent level of today’s CEO does not seem to have risen like their compensation levels. In fact, it appears that small, incremental improvements are all that’s required to make the big bucks. The Wall Street Journal’s David Wessel reports: “Take the number 1 ranked CEO and replace him with the CEO ranked number 250. This change would bring a drop in the market cap of the underlying company of .016%. That sounds miniscule, but it’s not. Take GE for example. A drop of that magnitude would equal $58 million and most of that difference goes into the CEO’s very deep pockets.” Very small talent differences translate into big compensation. Where do we sign up?
So much for job security. It appears we will all be replaced by computers before long. A recent study shows that over half of all stock market exchange volume will be driven by computer algorithmic trading in 4 years. Currently, computer based trading makes up a third of the volume totals. I think we all know that there will always be a place for a level headed professional to guide their client through tough times, and besides, a computer wouldn’t be much fun to golf with.
Last year we noted the shift in power in world finance from
New York to London . The reason often cited for this shift is the onerous nature of the Sarbanes Oxley law for companies wishing to list in the United States . It appears that the shift of influence is picking up speed. This week, Goldman Sachs took steps to beef up their London office to mirror their New York setup. The 2006 scorecard shows that New York needs to pick it up. There have been over 300 deals worth $83 billion that were brought to market in London, Tokyo and Hong Kong. In contrast, New York has done 147 deals worth $33 billion. I realize the comparison shows 3 exchanges competing with New York’s one, but in the past, the NYSE would have won this fight hands down.
Real estate returns have slowed over the last 18 months, but it appears that some sectors are still going strong. Morgan Stanley recently reported a 200% gain on their investment in London’s Canary Wharf . With a return that large, one would think that it took years to accomplish. In fact, they made the initial buy in the spring of 2003! How is that possible? The answer my friend is leverage. Morgan Stanley borrows $3 or $4 for each $1 of cash for its real estate deals. Don’t forget that leverage works both ways and the downside on that Canary Wharf trade does not bear thinking about.
We’ll conclude The Columns with a picture. Bennett Sedacca of Atlantic Advisors recently posted this 15 year chart. The white line is the Consumer Price Index and the orange line is the Producer Price Index. These indices are the two major gauges of inflation. They also represent a strong influence on the Federal Funds rate, represented by the yellow line below.
As you can see, the Fed Funds rate’s yellow line has not yet begun to dip. However, looking back further in the chart, one can see the correlation and the inevitability that the Fed Funds will fall. A drop in the Fed Funds rate is a mixed blessing. Yes, lower interest rates should eventually allow stocks to perform well. However, markets usually suffer through a sell off before the good times resume. Bonds tend to outperform stocks during this period, and the average drop of the stock market is somewhere around 6%. The sell off reflects the stock market discounting an economic slowdown. Finally, things should look up after the 2nd Fed Funds rate cut, as stocks take the lead and head higher. This shows the markets’ willingness to look past the slowdown into a time of economic strength. As always, charts are not predictors, but they offer an indication of how things have performed in the past. Just think back to the analog chart we posted this summer showing the S&P 500 from 1955. It was reassuring to have a guide to the markets’ potential.
I hope everyone has exciting plans for Thanksgiving. Thanksgiving is my favorite week of the year, and I feel we all have much to be thankful for. I want to thank all of you for a successful 2006.